Building a new house in Palo Alto

Friday, March 9, 2012

Well fans, it's official... Linsanity has hit Palo Alto. This week a tear-down in our neighborhood on Georgia Avenue sold for 1.65M...a whopping 455K above the asking price with a total of 38 offers. The frenzy has begun and boy are we in for an exciting season.

One of my favorite pastimes is scouting houses and observing sales trends around Palo Alto and nearby vicinities. By Thursday at noon, the new listings for the week are up on MLS ready for review. Inventory is low these days, so every new listing gets a quick scan with the noteworthy stats being house and lot size, location and price. The pricing game is a fun one to watch and often baffling to the uninitiated. When it comes to pricing strategies in the Bay Area, I've noticed there are two main approaches:

The "Price High and Wait" Strategy

Please sir, can I pay you some more?

This approach is typically used for high-end properties that tend to be the most expensive house on the block. They're often bigger and/or newer than the typical neighborhood standards so they don't fare well when you try to calculate a price based on sales nearby. Indeed, they are priced significantly higher than the estimated market value on Zillow or Redfin or any of the other real estate sites. Selling agents often describe this approach as "testing the market"--which is a fancy way of saying, I'm waiting to see if a sucker will bite before I lower the price to something slightly less absurd. These Richey Rich specials are easy to spot because you see the listing and immediately wonder what the seller is smoking and probably say to yourself, who in their right mind would pay that?! And if you've ever uttered these words, you're not their target buyer.

This approach can require months of waiting and price reductions but it can ultimately pay off, since you only need one price insensitive buyer to take the bait. Sometimes you get lucky and Facebook honcho Mark Zuckerberg decides to buy it (sans zip line and bat cave):

Or better yet, you hit the megamillions jackpot and Russian honey badger Yuri Milner drops a cool 100M on your pad. Honey badger don't care about resale value. It just takes what it wants. In the case of the Forest house, it was certainly worth holding out, the developer purchased the land in 2009 for $1,625,000 and likely made over $1M after all expenses. By the way, one of the selling features of the house was that it was built on property once owned by Marc & Laura Andreessen. Caché like this helps lure in honey badgers.

In lieu of staging the Georgia house, the
clever agent put up sexy comps instead

The "Under Pricing" Strategy
This list-low sell-high approach is by far the most prevalent strategy in Palo Alto where multiple offers are the norm. The strategy works by pricing a house below or in some cases, wellbelow market value to create a bidding war. It's based on the premise that buyers will compete for a deal and the more mayhem and madness you can stir up, the higher the players will jump to win. Using this strategy, homes sell lightening fast and often above market value. Take for example the Georgia house which was listed at $1,195,000 despite the fact that recent comps would suggest its value to be approximately $1.5 million. Here are the Georgia selling stats, courtesy of the listing agent:

The house was on the market less than a week and sold with a 14 day close. The top 12 offers were all non-contingent and closing in 21 days or less. And here's the kicker, half of these were all-cash offers. And this was not an anomaly. Check out some other February sales stats from Redfin agent, Brad Le:

South Palo Alto: On this $1.1m, ~1,100 sq. ft., 3 beds, 2 baths home, there were 16 offers. It went to an all-cash, no contingencies offer.

South Palo Alto: On a $950k, ~1,100 sq. ft., 3 beds, 1 bath property, there were another 16 offers, and more than one was all-cash. It went to an all-cash, no contingencies offer.

Menlo Park/Alameda Area: On a $1.2m, ~1,400 sq. ft., 3 beds, 2 baths home, the seller took a lower offer than the top, but it was an all-cash buyer with no contingencies and 3 free months of rent back.

Menlo Park/Flood Park Area: On a $1.2m, 1,890 sq. ft., 4 beds, 2 baths home there were eight offers, and it went to an all-cash, no contingencies offer.

Fortunately, the Chronicle's more even-keeled James Temple countered with Palo Alto housing is hot, but not that hot citing a 9.6% increase according to DataQuick, a real estate market research firm. My casual, albeit semi-obsessive, neighborhood watch supports the single digit increase. In terms of sale prices, the market hasn't gone stratospheric yet (with the exception of the honey badger who doesn't care market). Inventory is still extremely low. As Temple pointed out, only 61 houses sold in January, so sample size and percentage points aside, the Palo Alto market is definitely a tight one where all-cash buyers are winning.

Sure, on an absolute basis the market is ridonkulous. Nowhere else in the world do you have to have $1M+ in your pocket just to purchase a tear-down. But it's also a city filled with honey badgers who help protect that investment. If you can play in the market wisely, you can come out ahead with a winning investment.

Buying Strategies in a Competitive Market1. Find yourself a great real estate agent
I can't repeat this enough. First off, this is one of the biggest investments you'll make in your life. You want someone experienced helping you make smart decisions. Secondly, in a competitive market a great agent is the difference between winning and losing. Palo Alto real estate is an insider's game and the competition is fierce. One of the reasons we won the bid on our house is because the selling agent knew our agent Erika and trusted that our offer was solid and wouldn't fall apart during escrow. Before we made our bid, Erika stayed in close contact with the selling agent so that we knew exactly how many other offers we were competing against and the terms the seller preferred. This helped us decide how aggressive to be in our bidding. Also, Erika had sold several other homes in the neighborhood, so she was able to do smart comps and talk us through pros and cons. Now that we have the house, Erika continues to keep us up-to-date on the market and sends me to relevant open houses where I can get ideas for how to design our new home.

Finding a good agent does not mean finding someone who makes you feel good. In fact, if you're looking to buy in the Bay Area, a good agent will let you know it's not a cakewalk. A good agent will educate you on the market and probably show you crap holes that you wouldn't in a million years ever consider buying. The more you know about the market, the better your odds. My husband says it's like the famous poker quote: If you can't spot the sucker at the poker table, it's probably you. Don't be the bidder with less information and experience--you'll either lose the bid, pay too much or buy something you shouldn't have. It doesn't matter if you feel like the real estate market needs to be disrupted. Unless you want to pay Richey Rich prices, it's still an insider's game and hyperlocal. A great agent will help you buy the right house for the right price and the right terms.

2. Plot the comps & use available info to make judgment calls
When you're bidding on a house in Palo Alto forget about the asking price. It's irrelevant. Instead take a close look at recent comps. You want to look at similar homes in the neighborhood that have sold in the last year with special emphasis on the most recent sales. This is something that an experienced agent should be able to do pretty easily and in some cases, s/he'll have access to sales info that hasn't been made public yet. If you're lucky enough to be married to a crazy data geek strategic planner like my husband, you can plot these comps and build a predictive price model like so:

Comparables based on house size

Comparables based on lot size

Unfortunately, the strategic planner is hard at work on some other slopes (the kind in Tahoe) for a company-sponsored ski trip, so I'll have to do my best interpreting what I remember about the models. The gist of it is to do one plot of comps based on square footage of the houses and another plot based on the square footage of the lots. Your agent should help you select the appropriate houses to use as comps and remove any neighborhood outliers that will skew the model. The light blue dotted line shows what the price should be based on the other comps, the dark blue dots show what the house actually sold for.

Because we were planning a tear down, we cared most about the size of the lot. We used the first chart to decide what we'd have to pay to win it and the second chart gave us confidence that it was a good deal for a tear down. My strategic planner delights in the fact that we paid below what his predictive models suggested we should for our home, however this model doesn't factor in seasonality. More on this in #4.

In predicting a selling price, you can start with two estimates based on your comps: one from the house square footage chart and one from the lot square footage chart. Generally, the house square footage is a better predictor of selling price. There's less distance between the fitted line and the actual points. With these two estimates in hand, this is where you have to make some judgement calls. The Georgia house was a junker and not livable unless you like kitchens that look like a 1960's pizza parlor, choo-choo train wallpaper and a concrete court in the backyard (perfect for training the next Jeremy Lin!)

In theory Georgia should have been discounted because all the other comparables were nice, livable houses, but because these properties were all bought for lot value, the condition didn't matter. According to my husband's calculations, the Georgia house went for 5% above the prediction based on lot size, and 2% above the prediction based on house size. Not totally crazy, just somewhat aggressive. His recommendation is that if you want to be aggressive right now and win, bid 3-5% above the line to win, if you don't want to be aggressive, offer cash and bid the line to have a shot. If you don't have all-cash, you will likely have to bid significantly higher to be in the running.

I'm going to refrain from commenting too much on his advice because in our wedding vows, I promised not to mock my husband's spreadsheet models. What I will say is that his spreadsheet numbers often come out to be about the same as the ones that Erika gives us after tapping on her head a few minutes while pondering the current state of affairs. If the market does start to see a dramatic shift upwards in the coming months, you may wind up using comps that have already factored in an additional 5% increase, so be careful not to get caught up in a rapid upswing. A good agent will help you factor in common sense and market variables to these models. After all, it's hard to get true statistical significance based on a sample size of 3 to 4 houses.

3. Look for underappreciated properties
It's hard to find under appreciated properties in the Bay Area because everyone is looking for them, but you can get lucky sometimes if you and your agent are keeping a close eye on the market. When I was looking to buy a home in Mountain View, I fell in love with a quaint little house in the downtown area. It had fresh, pretty landscaping, was beautifully staged with the latest trendy paint colors and the glossy brochure bragged about how the house had been featured in Sunset magazine. It was listed in my price range, so I got quite excited. Meanwhile on the other side of town by Cuesta Park there was a house for sale in the same range. The Cuesta house was a probate sale with out-of-town sellers who didn't realize the value of staging a home. It was a no-frills offering. The house was empty, the walls were barren, the landscaping dismal. It was downright depressing. I took one look at it and said, thanks, but no thanks...I want the Sunset magazine house.

My agent made me go back to take another look at the Cuesta house. Imagine what it would look like staged, she instructed. Look at the backyard and picture nice landscaping. Erika predicted that the Mountain View buyers in my price range would be bidding on the Sunset magazine house and it'd go for a premium, while the Cuesta house would be ignored because it wasn't gussied up. Indeed, she was right. While the Cuesta house needed some work, it was in a better neighborhood and was an investment that I could easily add value to. I ended up being the only bidder on the house and got it for the list price while the Sunset magazine house had numerous bidders and sold 50K+ above asking.

The lesson here is that when there's an "it" house of the week, take a look around at the other properties on the market. While everyone is buzzing around the "it" house, there may be less competition than normal for other houses around town. The week that the Georgia house was on the market, there was an awesome house for sale less than a mile away. While 38 buyers were fixated on winning Georgia the other house only had 3 offers and sold to a buyer who was not paying all-cash. Incroyable, no?

4. Time the market
According to our agent, the slowest time of the year for the market is generally November through December. This is when we were able to buy our house slightly below market comps. Most people just don't want to move their kids in the middle of a school year, especially during the holidays. The market picks up with more inventory right after Superbowl weekend and is hottest in the Spring to early Summer. Our agent also says that election years tend to be good for sellers. This year's biggest unknown is the Facebook IPO. You can't go to an open house these days without hearing whispers about it. Everyone's wondering about the mythical beast and how it'll affect housing prices. Reports from recent sales indicate that there's more demand, more cash buyers and definitely more hype. The IPO is rumored to be happening by mid-May, so a 6-month lock-up period would lift sometime in November. If the Facebook Effect is real, the Fall may be a really good time to sell and a bad time to buy, which brings me to my last piece of advice, courtesy of the Gambler:

5. Know when to hold em', know when to fold em', know when to walk away, know when to run!
No one knows what the future holds. They say the best time to buy is when you don't need to since it affords you the luxury of waiting for a great opportunity. As soon as you have an inkling that you may want to buy and/or sell, talk to an experienced agent so that s/he can watch the market for you. We were looking for over a year and a half before we ended up buying last Fall. We were happy in our house in Mountain View but knew we would want to move in the next few years, so we kept an eye on the market. A great agent waits for the right opportunity and doesn't pressure you to buy or sell when conditions aren't optimal. A really great agent will educate you about resale value and talk you out of bad investment decisions. I fell in love with several houses that our agent talked us out of because of location or price. Don't get sucked into the emotion of winning a house. Do comps and make calculated decisions, understand the neighborhood's pros and cons. The market appears to be picking up, and as our agent pointed out to us after the Georgia sale, there are now 37 buyers in the market who just became a little hungrier to win. If you think you may want to get in the game, you can get our agent's contact info here: www.erikaenos.com. Erika will let you know when to hold, fold, walk away or run.

This is a great and useful analysis, Kay, and a bit terrifying given my wishful dreams of having Vicky & fam move down to the Bay Area from Portland (where they have a 3000 square foot house they bought for $420K). That said, when/if the time comes I hope Thomas won't mind sharing his spreadsheet templates!

Thanks, Ellen! It's been my experience that they calculate the addition without going to your house (they use the information found in your permits). For additions it's based on some square footage standards that they have, as long as they don't deem the house to be "substantially equivalent to new." For new construction they use comps for new homes in your neighborhood. For more detail, check out my post about property taxes: http://www.newpaloaltohouse.com/2012/04/low-down-on-property-taxes-and-ways-to.html